Can something called “tax expenditures” be the silver bullet to avoid a fiscal cliff and put the federal government on a better financial footing? Maybe so! Some think tax expenditures are the key to any budget deal in Washington.

So what exactly are tax expenditures? The term is somewhat misleading because logic suggests it means types of spending that are taxed. Instead, just the opposite is meant. Tax expenditures are certain kinds of spending made by households and businesses that are not subject to the federal income tax. So tax expenditures reduce the amount of tax revenue available to the federal government.

To see how tax expenditures work, here’s a brief tutorial on the federal income tax. The initial calculation of your federal income tax comes from multiplying your taxable income by the tax rate applicable to that income. So, if Sally Smith’s taxable income is $40,000 and the tax rate is 15 percent, then the federal income tax owed by Sally is $6,000 ($40,000 x 0.15). Once the initial tax owed is calculated, there may be a further adjustment to reduce that amount.

Tax expenditures can affect the tax owed in two ways. First, tax expenditures can reduce a taxpayer’s taxable income. Continuing with the above example, if Sally qualified for a tax expenditure of $10,000, then her taxable income would be reduced to $30,000, and her income tax bill would drop to $4,500. These kinds of tax expenditures are called tax deductions.

Second, certain kinds of tax expenditures can directly reduce the amount of tax owed after the initial calculation of that tax bill was made. Therefore, if Sally was eligible for this kind of tax expenditure at the amount of $2,000, her tax owed would fall to $4,000 ($6,000 minus $2,000). Such a tax expenditure is termed a tax credit.

I’m sure you’re now thinking, what are some examples of these great tax expenditures? The tax code is loaded with them, but a few of the more prominent are the mortgage interest deduction, the deduction for health insurance provided by businesses to their employees, deductions for donations to charities, a tax credit for low-income workers and a tax credit for child care payments.

Why do tax expenditures exist? There are two competing explanations. One says they are the result of special interest lobbying to help a particular part of the economy. Let’s say you manufacture widgets. If you can get a provision placed in the tax code that says people buying widgets get either a tax deduction or tax credit for the amount they spend on widgets, then you’ll likely see your widget sales increase.

The alternative explanation says government uses tax expenditures to encourage spending on products and services that benefit the public good. The tax deduction for charitable contributions is a good example. Supporters of tax expenditures for home-buying, health insurance and energy efficient vehicles also argue their products benefit society at large.

Which brings us back to today. The reason tax expenditures are potentially part of a budget deal is because they are very costly to federal coffers. If all the tax expenditures were eliminated, current estimates indicate annual federal government revenues would increase by near $1 trillion. That’s enough to eliminate the annual budget deficit. And this revenue could be raised without increasing tax rates, which is a sticking point for many elected officials.

It’s very unlikely all tax expenditures would be axed. Indeed, one idea floating around — that came up during the presidential campaign — is that all tax expenditures would be kept, but taxpayers would be limited to the total dollar amount they could claim. Other ideas are to keep some tax expenditures but reduce or eliminate others or reduce the tax expenditures available to certain taxpayers, such as higher-income households.

Regardless of what kind of plan is put forward to revise tax expenditures, it will be hotly debated for two fundamental reasons. First, current users of tax expenditures will see their tax bill rise if tax expenditures are curtailed.

Second, groups that benefit from tax expenditures — such as charities, the residential housing industry, child care centers and alternative energy providers — will likely be hurt if their tax expenditures are curtailed.

To see how this could happen, consider Sally Smith making a $1,000 contribution to her favorite charity. With a tax deduction for that contribution and using a 15 percent tax rate, Sally’s donation reduces her tax bill by $150 ($1,000 x 0.15), meaning her $1,000 gift effectively costs her $850. Charities worry that people like Sally won’t donate quite as much without the tax deduction because the cost of donating would be higher. Other groups benefiting from tax expenditures have the same worry.

So keep your eye on the coming arguments over tax expenditures. You decide if they should be a key part of any deal for fiscal frugality.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

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